The Paulson Plan, Money versus Debt, and the Reversal Auctions

The behavior of the US financial markets on Monday – the first day after the announcement of the Paulson Plan (the financial bailout of banks and non-banks through purchases of toxic debts and loans through reversal auctions) – was a surprise to many persons. There was no euphoria.

We believe that there are at least two major problems – if not more than two – with the Paulson Plan. First, the US Government is not issuing money, but rather good Government debt in order to buy bad loans. Therefore, the money supply and the monetary base are not increasing. If Milton Friedman was right about the Great Depression, then Bernanke is not complying with his promise made a few months ago in a famous speech about the Great Depression: “Never again. The Fed was wrong in the 30s. We are sorry.” The Fed should be issuing money, and the Treasury should not be issuing good Government debt (or, worse, raising taxes) to buy bad loans.

Second, the reversal auctions have perverse effects in many aspects. Naturally, the banks with the best balance sheets – let us say: Morgan and Bank of America – will be able to sell at very low prices their bad loans while the financial institutions will not be able to win the auctions because they cannot compete. So the banks and non-banks that really need to sell will not be able to clean up their balance sheets.

Worse, the other banks that were not part of the problem will have to mark to market their loans based on the new auction prices. This is why some good regional banks had major price declines today.

In our view, the Paulson Plan is very risky for all these reasons and one should recall the success of the Brady bonds issued for Brazil and Mexico in the nineties. It would be wiser for the US Government to issue Paulson bonds and give them as guarantee for the troubled banks to begin to clean up smoothly their balance sheets.

Going back to the Money versus Debt debate, consider the argument made by the economist John Rutledge:

“The Fed’s job is to provide liquidity. Instead, they diverted their energies to propping up troubled banks and investment banks by extending massive loans to institutions that were never eligible before. At the same time, they adopted procedures to sterilize the resulting reserve increases by selling T-bills in the open market to suck the additional reserves back out of the market. The net result was simply to shift bank reserves from healthy banks that were making loans to their customers to the sick ones. Total reserves did not go up at all. The monetary base has not grown in the past year. The Fed’s balance sheet has imploded. The upshot of all this is the Fed has provided no liquidity whatsoever and we have had one crisis after another. The FOMC statement, in writing about the balanced risks of growth and inflation shows they do not have a clue what is wrong with the system. The Fed does not print oil and should not chase growth-induced commodity price swings up and down with monetary policy. We don’t have an inflation: housing prices–the largest asset class for every American family–are still falling. It is time for the Fed to wake up and stabilize the markets.”

It seems that – just like in the 1930’s – the Federal Reserve is too worried about inflation and does not understand that one thing is to raise the money supply and the monetary base in order to generate life in the economy, and another thing totally different is to inject liquidity and then sterilize this new liquidity by selling Treasury bills and bonds.

Perhaps Ben Bernanke – who is considered an expert on the Great Depression – does not believe in the major argument of the Friedman and Schwarz book on the Great Depression.

Over and above that, one should also call attention to the writings of Hyman Minsky. His financial instability hypothesis raises some very interesting questions.

There are basically five stages in Minsky model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy.

The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.

As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid.